Creating value through responsible investment: Are the hard and lean going soft?

It is generally perceived that the private equity (PE) industry has lagged behind public companies in recognising the importance of effectively managing environmental, social, and governance (ESG) issues creating value for its shareholders. However, the ESG focus is increasing as the basic business model of the PE industry becomes more long-term, with more than 90% of the respondents in a recent survey of the PE industry believing that ESG activities can create value.

“We avoided 300 million litres of water use.”

Perhaps not something you’d expect to come from the report of a large private equity house. But it did – from the 2011 cumulative results of KKR’s Green Port- folio Program (GPP), which it launched in partnership with the Environmental Defense Fund (EDF) in 2008.

In the same year, Carlyle stated in their 2011 Corporate Citizenship report that the company expected to reduce costs by approximately $1.8 million per year, and eliminate about 5,000 metric tonnes of greenhouse gas emissions and 440,000 pounds of waste annually.

What’s going on in the corridors of private equity (PE) houses? When it comes to environmental, social and governance (ESG) issues, it wasn’t so long ago that the PE industry was viewed as somewhat ‘behind the curve’ compared to the corporate sector. Are the notoriously ‘hard and lean’ softening in their attitudes towards ESG matters?

Cautiously optimistic, PwC spoke to the leaders of some of the largest PE houses in Europe and the US to find out more. Ninety-four percent of them said that their attention to ESG issues will rise over the next five years. It’s clear that things are changing, but it is still early days.

Is it possible though, that the industry could accelerate its responsible investment (RI) journey? And if so, as the PE industry starts to identify value, and measure and report on its ESG efforts, could there be some shared learning for all.

So why this PE interest in responsible investment?

It’s the story of the stick and the carrot.

Investor pressure was the main catalyst cited by some PE houses we spoke to. Indeed, 88% said they believe that investor attention to ESG issues will rise over the next five years. So the pressure is real and it’s not going away. Increasingly, in a competitive fundraising environment, a robust RI strategy may be a source of competitive advantage, helping PE houses to secure access to capital. Survey respondents also said that risk management, cost savings, ‘tone from the top’ and regulatory pressure were important drivers.

The good news is that they can also see the money. A resounding 94% of the participants surveyed believe that ESG activities can create value. They see the carrot. A growing number of PE houses are being proactive about the ESG risks and opportunities of their portfolio companies. How can they create value from ESG matters? What opportunities can they find? This is a step change from their seeing ESG issues as solely about risk and compliance – the stick.

It’s work in progress – but could it change fast?

Whatever they say about their increased attention to ESG matters, our survey suggests that it is still ‘work in progress’ for PE houses. Of those we surveyed:

Fifty percent lack a policy on ESG issues and/or RI.

Only 40% have put systems in place to measure value created from initiatives (this is particularly relevant for initiatives addressing environmental and social issues which tend to have more direct impacts).

Forty-seven percent do not report publicly on their ESG programmes or their RI strategies.

This stems from the nature of the industry. Since they invest ‘private’ capital, PE houses have been under less pressure (political, regulatory and stakeholder) than their listed counterparts to show accountability and transparency. But, as they told us, this picture is changing rapidly. Limited partners (LPs) are upping the pressure for greater transparency.

So take note all you existing and future investees of PE houses!

The PE industry may be playing ‘catch-up’ but leverage is what it does. Even though many PE houses say that the lack of in-house capacity/expertise is a barrier to implementing an RI approach, they can learn from those who have already paved the way. They can avoid pitfalls and potentially make progress at a faster pace. Without the scrutiny of quarterly reports that listed companies face, PE houses can make change happen fairly rapidly in their portfolio companies, through their ownership status and their presence on company boards.

As we have continued discussing ESG matters with more and more PE houses, our survey findings continue to be reinforced. Over the coming years, we can expect an increasing number of case studies and ESG success stories from the PE industry.

What’s needed for RI strategies to flourish?

There are things beginning to happen that we’d like to see more of. Practices that could enhance the value of responsible investment strategies across the board, whether you’re a PE house, an investor, a limited partner, a portfolio company, or sitting in another industry.

1) Shift the paradigm – and then don’t forget the carrot

If we can see things differently, change can start to happen. Ninety-four percent of PE houses are now starting to see differently – ESG activities are opportunities for value creation, not just matters of risk and compliance. But have they focused enough on that carrot yet, or are they still more concerned about the stick?

Let’s look at due diligence.

All survey respondents say they do some type of ESG due diligence, pre-acquisition. This could be misleading though. All PE houses will carry out ‘traditional’ environmental, health and safety due diligence, typically at a site level. Things like contamination liabilities, asbestos risks and environmental regulatory compliance have all been at the centre of specialist investigations in the past. This is mainly about checking for any financial implications that could impact investment economics; or for legal and compliance reasons; or to uncover liabilities that would expose the PE house. It’s still about the stick.

Of course, this type of due diligence still has to be done. But adding ESG due diligence paints a fuller picture. It identifies a broader range of issues like climate change or water scarcity. These might impact the quality, availability or price of raw materials in the future. ESG due diligence considers opportunity: new markets; income streams; eco-efficiencies; new resources; employee motivation; employee loyalty. It’s about the carrot as well as the stick.

These kinds of ESG due diligence findings then need to be built into the 100-day plan (or other targets). If this doesn’t happen, there’s a risk that ESG action points will be sidelined as niche issues. They won’t be integrated into core business strategy and practice. ESG value creating opportunities will be missed. The carrot forgotten.

2) Measure the financial value created – yes, tangible and intangible

While 94% see that ESG activities can create value, only 40% are measuring it. What’s more, the things that are being measured quantifiably tend to be the ‘easier to measure’ energy efficiency initiatives.

PE houses such as KKR and Doughty Hanson have successfully measured cost savings from eco-efficiency initiatives including waste reduction, raw material reduction and reduced energy/water use. This is data that can be expressed in financial terms.

However, even the more advanced PE houses are struggling to measure the less tangible benefits of ESG issue management. Why is this?

It’s difficult to get the information. To measure value created from environmental and social initiatives you need relevant financial data. For most PE houses this is not yet readily available at a portfolio level. Many interviewed said they’re not yet collecting ESG data systematically from portfolio companies.

Other PE houses are measuring and monitoring ESG improvements at their portfolio companies. But they’re using qualitative techniques. They can’t attribute value in financial terms to any improvements, but they can still build a picture of progress. They can also compare performance company -to-company, and year-on-year.

Interestingly, houses that are monitoring and reviewing ESG performance at a portfolio level are increasingly asking the portfolio companies themselves to pay for the cost of carrying out these reviews. This is partly because they recognise that ESG management is about value creation as well as risk management and compliance.

So what’s the answer? Use existing valuation methodologies. These can effectively quantify both the intangible and tangible value from managing environmental and social issues. This kind of valuation exercise first requires access to data though. PE houses must have the ability to systematically collect relevant ESG and financial data from their portfolio companies.

As we saw at the beginning of this document, some PE houses are starting to capture and report impacts more fully. Let’s take a further look at KKR.

3) Ramp up reporting – for the sake of all stakeholders

There has been a trend among some PE houses to report ESG progress on a case-study basis. This can be a particularly effective reporting tool post-exit, to show the value created while the company was owned by the PE house.

But soon case studies won’t be enough. LPs are paying much more attention to the data they are getting from PE houses. They are asking more of them in their questionnaires. They are pressuring for more transparency in ESG-related information.

Figure 1

The good news is that PE houses can benefit greatly from the progress in the corporate sector on sustainability reporting and integrated reporting. Which key performance indicators (KPIs) should be included in reports? What metrics can be used to measure intangible value from ESG activities? Here’s an example (See Figure 1):

The second piece of good news is that PE houses can share this knowledge effectively across their portfolio companies during the hold period. They can strive for consistent reporting from all portfolio companies. They might host knowledge-sharing conferences for portfolio companies to learn from each other. They can call on specialists to help transition portfolio companies through the process.

Some PE houses have already set mini- mum ESG reporting metrics or KPIs such as the ones above. They expect portfolio companies to measure, monitor and report upwards, based on these.

With consistent reporting in place, the PE house gets a view of individual company progress over time. They can also compare, company-to-company, typically within a given sector.

As they become more sophisticated in reporting, PE houses can engage more proactively with LPs. They can work together to shape and streamline future RI reporting to them rather than being on the back foot and struggling to report similar, but different, information to individual LPs. CalPERS is doing just this by developing a ‘Manager Assessment Tool’ to help its manager selection process by ranking managers on key ESG issues.

Are we brave enough to go this far?

So, fast-forward a few years. PE companies are taking a strategic, value creating approach to ESG issue management. They have increased their knowledge through innovative partnerships with NGOs. Deal teams have been trained on responsible investment. There’s more structure around measuring and reporting the value of ESG programmes. Portfolio companies are enjoying the benefits of a proactive ESG approach. LPs are receiving transparent, insightful information.

At this point the PE industry could be in a position to give something back. Sitting atop integrated reports, consol- idated from across their portfolio companies, using a consistent set of KPIs gives them a great advantage.

At this aggregate level, sector-based ESG issues and opportunities will become apparent. By sharing the insight from the integrated reports back through their portfolio companies they can create a domino effect of sector-specific learning.

PE houses will have enhanced their understanding of the most useful KPIs to include in an integrated report from a sustainable accounting point of view. They can share these with the industry actors in the corporate sector.

Limited partners could use the insight gained from their private equity invest- ments to the benefit of their public equity ones. And as LPs start demanding integrated reports and using the PE model for their public equity asset managers, they would drive further transparency in ESG-related information.